Prospects for Northeast Asia in the 21st Century

I would like to thank Mina Kim for research assistance.

Introduction

Northeast Asia is today undergoing a process of significant economic change. Japan is emerging fitfully from its "lost decade." South Korea is recovering from its economic crisis. China continues to grapple with its transition into a market economy. Taiwan, which weathered the crisis relatively well, faces considerable political uncertainty. Russia as a whole remains mired in an economic crisis, with the Russian Far East being hit particularly hard, as the pattern of economic activity is rationalized. In North Korea, the economy has collapsed creating a famine and leaving the country dependent on external support.

Japan is the largest and richest economy in the region. Events in Japan will have a significant impact on regional development. Although most observers expect growth to slowly return, the country faces three problems in declining order of immediacy (Table 1). First, there is the need to maintain aggregate demand which is complicated by the country's deflation. Second, outstanding financial sector problems must be addressed. Third, there is a need for deregulation and restructuring outside the financial sector.

With regard to the immediate aggregate demand problem, the conventional response is fiscal stimulus, and Japan has pursued an expansionary fiscal policy largely in the form of increased public works expenditures. However, the pattern of expenditure is questionable: projects have been undertaken for political reasons, and many of these projects have low or even negative rates of return.¹ On paper, net government debt (assets less liabilities) is relatively low, but it is questionable whether some public assets are worth their reported value. Moreover, given that most observers expect two more fiscal stimulus packages before elections next year, some question the ability of the bond market to absorb additional government debt.

Monetary policy is the other tool of macroeconomic management, and Japanese monetary policy has been the subject of considerable controversy as of late. The basic problem is that although nominal interest rates are near zero, real interest rates remain relatively high due to deflation. The Bank of Japan argues that, under these circumstances, monetary policy is relatively ineffective-increased injections of liquidity would not reduce interest rates or increase the demand for credit. Increasing the money supply would amount to "pushing on string."

The counterargument is that the Bank of Japan could monetize government debt. This would contribute to inflation, which would reduce real interest rates and encourage the depreciation of the yen. (Some commentators have advocated explicit "inflation targeting" in which the Bank would print yen until a specified rate of inflation, say two percent, were attained.) Indeed, concerns about the recent run-up in the yen have been the main impetus for the Bank of Japan to relax monetary policy. These concerns may be misplaced, however.

Since most of Japan's output is not traded internationally, the exchange rate should really be a secondary concern. Besides, at its level today, Japan's real effective exchange rate is in the middle of the range of values that it has taken in the 1990s-the yen today is not overvalued. As evidence of this, Japanese exporters have not been raising their dollar prices for exports, but instead have been absorbing the yen appreciation in reduced profit margins. Finally, to the extent that a stronger yen encourages imports from the rest of Asia this is a good thing-the Asian countries are recovering from severe crises and are poorer with less stable social and political systems than Japan. Conversely, a weak yen could harm the rest of Northeast Asia. South Korea, in particular, would be harmed, as a weak yen would reduce South Korean competitiveness both in Japan and in third country markets such as the United States.²

The South Korean economy is expected to grow strongly in 1999, though concerns remain about the sustainability of its recovery into 2000 and beyond. Much of the current growth has been due to a rebound in consumption from extremely depressed levels in 1998, inventory restocking, and fiscal stimulus. Employment in the core sectors of the economy (industry, agriculture, and services) has remained weak with much of the recent increase in jobs coming from self-employment and the public sector. While considerable amount of restructuring has occurred among the smaller chaebol and in the small and medium enterprise (SME) sector driven by the credit crunch, restructuring in the largest chaebol has dragged. The question for South Korea, like Japan, is whether fiscal stimulus in the absence of restructuring and improvements in efficiency is an adequate recovery strategy. Again like Japan, South Korea faces elections next year. The government has announced another expansionary budget, and there are concerns that, with the immediate crisis receding, so will the impetus for reform. Indeed, some argue that a Grand National Party victory in the National Assembly elections could retard reform even further.

The problems of reform are deepest in China. The Chinese economy has been slowing under the twin pressures of waning international competitiveness and ongoing restructuring of the state-owned enterprise (SOE) sector. Between 1992 and 1998, employment by SOEs and urban collectives fell by 30 million workers. During the same period, employment in private and foreign-invested enterprises increased by 31 million. Some of the decline in SOE employment was illusionary as SOEs were converted into joint stock companies without fundamentally changing managment or financial operation. Nevertheless, a tremendous transformation of the Chinese industrial landscape is ongoing.

Unemployment has increased significantly. There is an imperative to maintain aggregate demand to absorb displaced labor and new entrants into the work force. During the Asian financial crisis, China received considerable praise for not devaluing the reminbi (RMB) during the Asian financial crisis. However, the price paid has been declining international competitiveness and increasing balance of payments pressure. No one believes that the current policy of nominally pegging the value of the RMB to the US dollar is the optimal exchange rate policy for China. A managed float or some kind of basket peg in which non-dollar currencies such as the yen receives a significant weight would be preferrable. As a consequence, it it likely that China will move to a new exchange rate policy sometime in the future and attempt to engineer a modest devaluation at that time. It is unlikely that such an action will occur during sensitive negotiations over China's accession to the World Trade Organization (WTO). Instead China could be expected to wait until the WTO negotiations have been concluded successfully (or until it concludes that successful completion is unlikely) before moving on exchange rate policy.

A devaluation of the RMB would improve China's international competitiveness and have a modest negative impact on Japan and South Korea. Noland et al. (1999) report that a five percent real depreciation of the RMB would increase China's trade surplus by around $20 billion. Exports from Japan and South Korea would decline modestly as Chinese enterprises substituted domestically produced industrial intermediates for imports. The economies of Southeast Asia would also be adversely affected as Chinese exporters took market share in third country markets such as the US. Of course the real question is how currency markets would react to a Chinese devaluation. Although the situation in Asia today is better than a year ago, a Chinese devaluation could re-ignite financial market turmoil and another round of competitive devaluations.

The issues facing North Korea are on a completely different order of magnitude.³ The country is in its nineth year of economic decline, and a famine has claimed the lives of perhaps ten percent of the pre-crisis population. This is fundamentally a systemic crisis, not a period of aberrant performance due to bad weather or unfavorable external shocks, though both have contributed to North Korea's current predicament. In response the regime has pursued essentially two coping strategies. The first has been the use of implicit or explicit threats to extract resources from the rest of the world. In this regard, recent diplomacy which holds forth the possibility of stopping the North Korean nuclear weapons and long-range missile programs and normalizing the North's relations with the rest of the world is potentially a major step forward..

The second coping strategy has been the pursuit of "one-off" projects to generate foreign exchange without affecting the systemic conditions of the economy. These would include the Rajin-Sonbong special economic zone (SEZ) and the Mt. Kumgang tourism project. The October 1998 agreement between Hyundai and Pyongyang is important in this regard. First, payments committed to by Hyundai dwarf anything that North Korea could plausibly earn in Rajin-Sonbong, and second the Hyundai agreement extends the possibility of the construction of a new SEZ.

With respect to the former, Hyundai has guaranteed North Korea $942 over 75 months, with the payment schedule front-loaded for the first six months. (Indeed, the North Koreans used brinkmanship to extract upfront payments before the first tour visited Mt. Kumgang in November 1998.) At $300 per passenger, North Korea stands to make $450 million per year off the tourism agreement alone in the admittedly unlikely case that Hyundai is able to fill all its berths. To put this in perspective, this money, if properly deployed, would be enough to close the North Korean food gap and end the famine. Unfortunately, it is believed that the funds are going into the Hong Kong bank account of "Bureau 39," a party organization controlled by Kim Jong Il, to be used to reward his cronies and prop up his rule. If this is how the Mt. Kumgang tourism project plays out, it will amount to a successful version of what Rajin-Sonbong is not - a regime-preserving hard currency earner with no real systemic implications for the organization of the North Korean economy or society.

In this respect, the rest of the Hyundai deal might be more significant. The agreement also calls for the development of a second SEZ in Haeju, north of Inchon. This appears to have far greater prospects than Rajin-Sonbong. First, the geographical location is far more auspicious. Second, it has the backing of Hyundai (and presumably the South Korean government). This is critical both from the standpoint that it provides the necessary infrastructure (which Rajin-Sonbong sorely lacks) and carries the imprimatur of Hyundai (and by extension the South Korean government). Thus, South Korean SMEs are far more likely to move light manufacturing operations to Haeju than Rajin-Sonbong.

Complementarity and Integration

The complementarity and basis for integration among the major economies of Northeast Asia is easily understood. The real question is how North Korea might integrate with its neighbors were it to undertake economic reform. For one thing there would be a reallocation of factors according to comparative advantage.⁴ Based on the experience of other transitional economies, one would expect significant reorientation of international trade away from socialist allies and toward natural trading partners. One way to get a sense of how North Korea might look as a "normal" country is to use a standard gravity model of bilateral trade to simulate its post-reform trade pattern. The regression model, originally estimated by Frankel and Wei (1995), characterizes the volume of trade as a function of size, income level, proximity, adjacency, participation in regional economic integration schemes, and cultural similarity. North Korean values of these explanatory figures are then substituted into the gravity model regression to generate North Korea's "natural" pattern of trade (Table 2).

According to this analysis, North Korea's natural trade partners would be South Korea, Japan, China, and the United States, in that order. South Korea and Japan alone would account for nearly two-thirds of North Korea's trade. Moreover, the share of international trade in national income would roughly quintuple as indicated in the memorandum item (though the resource reallocation associated with such a large increase in trade would almost certainly boost income significantly as well). This gives some indication of the potentially dramatic scope for change in North Korea.

These results refer to aggregate trade. North Korea's prospective comparative advantage is analyzed using disaggregated trade and investment data for North Korea, South Korea, and Japan. Initially, data for North and South Korea are subjected it to five filters: 1) sectors in which North Korea had a "revealed" comparative advantage, defined as the ratio of North Korea's share of world exports of a particular commodity category to its share of world exports as a whole; 2) sectors in which "revealed" comparative advantage had increased between 1980-1992; 3) sectors in which South Korea has declining "revealed" comparative advantage; 4) sectors in which Noland (1991b) projects South Korean export shares to fall; and lastly 5) sectors in which the growth of South Korean outward FDI has exceeded that of the economy. The list is debatable-one might not expect North Korea's current exports, in essence the residual of the plan, to necessarily be the exports in a reformed, market economy. Nonetheless, this seems like a reasonable place to start. Twenty-five of the original 465 sectors meet all five criteria (Table 3).

The most promising sectors for North Korea are primary products such as fish and minerals, as well as manufactured goods such as textiles and apparel. Although South Korea had been the rice bowl in the past, if trade were opened today, North Korea could become a net exporter of agricultural goods to the South, especially if capital markets were relatively unified and labor markets were not. This is a very conservative list.⁵ By loosening the criteria to include, for example, sectors in which Japanese FDI has been high, the list of candidate sectors is lengthened. Additional goods that meet an analogous filter for Japan are reported in Table 4.⁶ There are no big surprises here either. The additional 12 products are mostly natural resource products.⁷

Since North Korea's current exports might not provide a useful signal of its future exports, the data are reanalyzed focusing exclusively on the South Korean and Japanese data. A similar set of criteria are employed: sectors in which both countries have "revealed" comparative advantage; sectors in which this "revealed" comparative advantage has been declining over time; sectors in which both countries have been forecast to lose competitiveness; and sectors in which the rate of outward FDI in both countries has been higher than national income. The additional fourteen sectors that meet these criteria are listed in Table 5. With the exception of two agricultural categories, these are all light-industry sectors. In summary, an analysis of the North Korean, South Korean, and Japanese trade and investment data suggests that North Korea's sectors of prospective comparative advantage would largely be in primary products sectors in which North Korea's natural resources convey a comparative advantage, and light manufacturing industries which are declining in Japan and South Korea, but could be competitive in lower wage North Korea.

This preceding analysis has been done partly on the basis of historical experience. It is possible that with the recent appreciation of the yen, the future industries of greater capital intensity (auto parts, for example) than those listed in Tables 3 through 5 could be candidates for relocation to North Korea.⁸ Overall, these sectors are consistent with the sectors identified by Hyundai for its prospective Haeju SEZ.⁹

Nevertheless, this preceding analysis, along with the huge increase in trade indicated in Table 2, would imply an enormous change in the composition of North Korean output away from heavy toward light industry. Noland, Robinson, and Scatasta (1997) and Noland, Robinson, and Wang (1999), using far more sophisticated computable general equilibrium models found that integration with the rest of the world could lead to large increases in income and significant shifts in the composition of output and employment.

Conclusions

The economies of Northeast Asia face significant challenges as they enter the new millenium. Each country will largely determine its own future. Nevertheless, there are some regional interactions. Developments in Japan will obviously affect outcomes elsewhere in the region-for better or for worse. The possibility of a Chinese devaluation has implications of other regional economies. The region may encounter some external shocks such as a rise in oil prices or economic slowdown and/or an increase in protectionism in the United States.

Developments in North Korea are the hardest to predict. The country has been under serious systemic stress. The recent Perry Initiative would appear to open new possibilities for normalizing relations not only with the US, but other countries in Northeast Asia as well.¹⁰ Normalization with Japan, for example, would permit the Japanese investment guaranty agency to insure Japanese investments in North Korea and pave the way for mainstream Japanese firms to make large-scale investments. It could also lead to the resolution of post-colonial claims, which could potentially amount to billions of dollars. Such funds, properly deployed, could restore North Korean access to world capital markets and contribute to economic rehabilitation. Membership in international financial institutions such as the World Bank and the Asian Development Bank would be another possibility.

However the likelihood of successful reform should not be overstated. The regime faces internal obstacles to reform. To cite one example, it is possible that the military, probably the most coherent institution in the society, with privileged access to economic assets, could be a prime beneficiary of reform. However, it may well oppose reform if it believes that this will endanger the nation's military security. This suggests that economic reform is unlikely to occur before some rapprochement with South Korea.

Even without the diplomatic precursors, North Korea's reform path would be more difficult than the ones that have been traversed by China and Vietnam, Asia's two other major transitional economies. Propitious initial conditions have facilitated successful reforms in China and Vietnam. At the time they initiated reforms, China and Vietnam had more than double the share of population employed in the agricultural sector than North Korea apparently has today, and their reform strategies were made possible by the existence of this enormous pool of low productivity labor In these countries, the state-owned heavy-industry sector was initially relatively small (Table 6). China and Vietnam were able to initiate reforms in the agricultural sector where the price liberalization provoked a rapid efficiency gains, freeing up low productivity surplus agricultural labor to be absorbed by the emerging, non-state or semi-private light manufacturing and service sectors.

The initial conditions of China and Vietnam are irreproducible and such a path does not appear to be viable for more industrialized centrally planned economies (CPEs).¹¹ Piecemeal reforms have not been successful in industrialized CPEs facing economic crises. The more highly interdependent nature of industrial enterprises has meant that a whole host of reforms-macroeconomic stabilization, introduction of rational pricing, liberalization of international trade and introduction of a convertible currency, tax, bankruptcy, and social safety net reforms etc.-are a seamless web and must be done simultaneously for reform to be successful economically and sustainable politically.¹² Even in the cases of China and Vietnam, adjustment in the old state-owned heavy-industry sector has proven to be difficult. This agriculture-driven transition path is simply not available to North Korea, which in economic terms more closely resembles some of the economies of Eastern Europe than it does China or Vietnam.

The second hurdle that North Korea faces is ideological. Consider the case of Vietnam. The North Vietnamese government and their Vietcong allies defeated the South Vietnamese government in a civil war, allowing them to claim an ideological monopoly in the united Vietnam. Likewise, while China has contended with the rump of Taiwan, no one seriously has claimed that the Taiwanese historically represented an ideological threat to the Chinese government. The point is that reformers in both China and Vietnam had been relatively free to construct tortured rationalizations about how their market-oriented reforms were what Marx, Mao, or Ho really had in mind.

The ideological terrain faced by the current North Korean regime is very different. Rather than monopolist purveyors or dominant definers of national ideology, the North Koreans clearly are junior partners, both in size and achievement. Moreover, the dynastic aspects of the Kim regime make it even more difficult for the son to disavow the legacy of the father. And while the ideologues of Pyongyang can certainly try to reinterpret North Korean founder Kim Il Sung's philosophy juche to mean market-oriented reform, the existence of a prosperous, democratic South Korea makes their task very difficult, indeed. After all, why be a second-rate imitation South Korean when one can head south and be the real thing?

This, of course, raises a third point. The sheer scale of change that is likely to accompany significant liberalization could be tremendous. North Korea is probably the most distorted economy in the world. Liberalization could mean huge changes in the composition of output and employment. International trade would become far, far more important, and most of that trade would be with South Korea and Japan, two countries with which North Korea maintains highly problematic relations. While today's North Korean economy has unexploited latent potential, its isolation means that there is no institutional mechanism through which this latent potential can be transformed into products that the rest of the world would want to buy. Even in the case of China, a significant part of the vitality of China's international trade sector can be attributed to foreign-invested enterprises which account for as much as 40 percent of Chinese exports (Naughton, 1996, Table 3). In prosaic terms, North Korean enterprises need blueprints and worldwide distribution and marketing networks.

As a consequence, Pyongyang may fall back to a much more limited strategy of opening. Tourism projects, mining concessions, and SEZs can help relieve balance of payments pressure, but whether such a strategy is sufficient to restore growth and ensure political stability is another matter entirely.

Table 1: Growth Forecasts

Table 2: Unemployment by level of education (Percent of total unemployment in 1996)

Table 3: Trade-weighted averages of the ratio between high school and college educated employees, all manufacturing in the United States (1979 and 1990)

Table 4: Breakdown of exports by region (Percent of each region's exports in 1996)

Table 5: Breakdown of Imports by Region (Percent of each region's imports in 1996)

Table 6: Distribution of Labor Force at Time of Reform

References

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Kemme, David M. And Michael Marrese. 1997. "Economic Transition and Economic Performance: Lessons from Eastern Europe and the former Soviet Union," in Doowon Lee ed. The System Transformation of the Transition Economies. Seoul: Yonsei University Press.

Lee, Shi-Young. 1998. "Prospects for Trade Between the Two Koreas," in Yang Un-Chul editor, The Political Economy of Korean Unification. Seoul: The Sejong Institute.

Lipton, David and Jeffrey Sachs. 1990. "Creating a Market Economy in Eastern Europe: The Case of Poland," Brookings Papers on Economic Activity 1990:1 75-148.

McMillan, John. 1997. "What Can North Korea Learn from China's Market Reforms?," in Doowon Lee ed. The System Transformation of the Transition Economies. Seoul: Yonsei University Press.

Naughton, Barry. 1996. "China's Emergence and Prospects as a Trading Nation," Brookings Papers on Economic Activity, 2 273-344.

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Noland, Marcus. 1991. "Prospective Changes in the Commodity Composition of U.S.-Korea Trade," Joint U.S.-Korea Academic Studies 1

Noland, Marcus. 1999. Stumbling Toward the Apocalypse: Economic Turmoil on the Korean Peninsula. Washington: Institute for International Economics, forthcoming.

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Noland, Marcus, Sherman Robinson, and Monica Scatasta. 1997. "Modeling Economic Reform in North Korea," Journal of Asian Economics, 8:1 15-38.

Noland, Marcus, Sherman Robinson, and Tao Wang. 1999. "Rigorous Speculation: The Collapse and Revival of the North Korean Economy," Working Paper 99-1. Washington: Institute for International Economics. O, Wonchol. 1995. "A Response to North Korea's Food Crisis," revised and edited English translation of "Ssalboda nonsabop wonjo p'ilyo," Sin Dong-A September, 460-76, Canberra, Australian National University.

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Notes

1. Indeed, the problem of "pork barrel" politics is such that it would be preferable for fiscal stimulus to take the form of tax cuts instead of direct public expenditure. Although some of the tax cuts would go into saving, not all would be saved, and the resultant expenditures would be on goods and services wanted by households - not those that bureaucrats and politicians find most advantageous. The impact on the composition of demand would reinforce the restructuring of the Japanese economy toward greater efficiency. To the extent that the tax system also embodies inequality, tax cuts would enhance equity.

2. Noland et al. (1999) report a number of simulations of alternative Japanese recovery strategies using a computable general equilibrium model of 14 sectors and 17 regions, including South Korea, China, and the United States.

3. See Noland (1999) for a comprehensive analysis of these issues.

4. Were reform accompanied by a reduction of political hostilities with the South, there could also be a significant demobilization of the military and a release of productive factors for alternative uses.

5. O (1995) asserts that a reformed North Korea could have a comparative advantage in fruits, vegetables, dairy products, and meat (including beef, chicken, and pork).

6. The criteria were: 1) sectors in which North Korea has a "revealed" comparative advantage; 2) sectors in which North Korea's "revealed" comparative advantage had increased between 1980-1992; 3) sectors in which Japan has declining "revealed" comparative advantage; 4) sectors in which Noland (1990) projects Japanese net exports to fall; and 5) sectors in which the growth rate of Japanese outward FDI has exceeded that of the economy.

7. The inclusion of the two raw wood sectors is problematic. North Korea currently is exporting raw wood to China, but this does not appear sustainable. Moreover, the original North Korean data do not include imports from Russia, nor probable illegal imports from Indonesia and the Philippines. As a consequence, North Korea's comparative advantage in wood products is probably weaker than Table 3 would suggest.

8. GM, for example, has expressed interest in constructing an auto parts plant in Rajin-Sonbong (Financial Times, 17 June 1995).

9. At a press conference on 1 November 1998, Hyundai Chairman Chong Mong-hon identified light industrial products, shoes, clothes, needlework, woven goods, spinning, toys, kitchen wares, assembled metal products, precise machines, metal machine tools, plain operating machines, leather goods, bags, textile goods as promising sectors for investment in the North on the basis of their labor intensity. In addition, TV assembling, radio, fans, electronics parts, plastic goods, synthetic rubber processing, and machine parts have been declining competitiveness in the South and could be produced "with mutual cooperation." Beverages, food, cigarettes, and pulp for which raw materials are "easy to obtain" could also be produced in the North. See also S.Y. Lee (1998) who performs an analysis similar to the one above-and obtains results similar to those reported above.

10. President Clinton recently announced a partial lifting of the US embargo. If the US were to lift the embargo on North Korea fully it would have to establish a policy toward the treatment of textile and apparel imports. These are currently subject to bilateral quotas under the Multi-Fibre Arrangement (MFA). It has been argued in some circles that if North and South Korea were to treat inter-Korean trade as domestic trade, then any imports of textiles and apparel from North Korea would have to be counted against the current South Korean quota. It would immediately raise the difficult issue of devising a quota allocation mechanism or formula between North and South Korea. Rather than counting North Korean imports against the South Korean quota, it would be politically more expedient to allocate North Korea a small quota (which might be offset fully or partially from a US perspective through South Korean acquiescence in the reduction of its quota). In the case of Europe, North Korea does not currently fill its existing MFA quotas.

11. See Riedel (1993) and Sachs and Woo (1994). Oh (1993), Naughton (1997), and McMillan (1997) address the relevance of China's reforms to the North Korean case.

12. See Lipton and Sachs (1990), Sachs and Woo (1994) and Kemme and Marrese (1997).